Background

While Luxembourg already offers an attractive toolbox and significant flexibility for structuring carried interest, different interpretations have emerged regarding the tax treatment to apply. In addition, the specific tax regime for carried interest introduced a few years ago was transitional and restrictive in scope, considering the number of conditions to be met.

The proposed tax framework aims to remove ambiguity and align the Luxembourg tax treatment with market realities.

Key measures

Clarification of carried interest types and applicable tax treatment

The draft bill distinguishes between two categories of carried interest for Luxembourg tax purposes — contractual carried interest and participation-linked carried interest — as follows:

• Contractual carried interest: This is carried interest received exclusively on a contractual basis, with no required investment by the carried interest holder in the AIF.

Contractual carried interest is now clearly defined and recognized as extraordinary miscellaneous income, benefiting from a favorable taxation at one-quarter of the standard global income tax rate in the hands of the Luxembourg tax resident carried interest holder (up to 11.45%).

• Participation-linked carried interest: This is carried interest "indissociably linked to a direct or indirect holding in an AIF" or "when it is represented by such a holding." In practice, this covers either the situation where the carried interest holder holds a direct or indirect participation (which he/she has acquired himself/herself for valuable consideration) in the AIF or the situation where the carried interest holder invests in the AIF via an ad hoc vehicle (e.g., a Luxembourg special limited partnership or a foreign partnership).

From a Luxembourg tax perspective, on the one hand, the remuneration received from the participation not representing the carried interest should remain subject to the Luxembourg ordinary tax regime.

On the other hand, the remuneration representing the carried interest is recognized as speculative income but no taxation should arise at the level of the Luxembourg tax resident carried interest holder, if the participation has been held for more than six months and the said individual does not hold a substantial shareholding (i.e., does not hold more than a 10% shareholding, as defined in Article 100 of the Luxembourg amended income tax law of 4 December 1967).

To avoid complicating the taxation of Luxembourg tax resident carried interest holders in cases where the AIF is transparent for Luxembourg tax purposes, this transparency should be disregarded for the sole purpose of applying the carried-interest tax regime to these individuals. The carried interest income should continue to be considered as speculative income, regardless of the nature of the income received by the tax transparent AIF.

Finally, the draft bill proposes to abolish the specific transitional tax regime for carried interest introduced a few years ago. If certain managers still benefit from this regime, they should automatically switch to one of the two categories of carried interest mentioned above, which should not be less advantageous.

Expanded beneficiary scope

The draft bill aims to extend the proposed tax framework to all natural persons holding carried interest, who are either managers or, directly or indirectly, in the service of managers or management companies of AIFs, whatever their status (e.g., an employee of an advisory company, a partner of a management company, an independent board member of the AIF). However, this would be subject to the limits of any abuse that would consist, for example, in disguising a fixed income or bonus in order to benefit from a more advantageous tax treatment.

Removal of the full recovery investment condition

The proposed changes remove the existing condition that carried interest may only benefit from the preferential regime after investors have fully recovered their invested capital. This change ensures that "deal-by-deal" carried interest structures are now covered.

Practical implications

This reform offers much-needed legal certainty for fund managers and tax advisers structuring carried interest plans. It could significantly enhance Luxembourg's appeal to portfolio managers, especially amid growing competition with other fund domiciles.

Some key action points for stakeholders are as follows:

• Review existing carried interest schemes: assess whether existing structures will qualify under the modernized tax framework.
• Consider Luxembourg relocation: assess to what extent the modernized tax framework may incentivize talent relocation.

Next steps

The draft bill still requires parliamentary adoption and State Council review. However, swift adoption is likely given its targeted scope and alignment with coalition priorities. Once enacted, the changes will apply from the 2026 tax year.